The Invisible Advantage

Summary
Jonathan Low presented the findings from his research on intangibles as the drivers of company value. Financial markets are already using intangibles such as leadership, reputation, brands, human capital and intellectual capital as important factors in determining companies’ value. His research shows that there is a direct correlation between these factors and financial outcomes of companies. Companies need to do a better job of identifying and managing these intangible assets.

Policymakers also need to be aware of the importance of these factors. The current system of measuring what is driving business value – based on traditional financial measures – is seriously broken. New systems that account for intangibles are needed if we are to properly allocate capital or develop effective economic policy (such as tax policies).

In his role as respondent, John Mitchell raised the basic question of finding a balance between corporate and individual rights over these intangibles assets. The discussion that followed raised a number of questions including: how to account for non-controllable intangible assets, the role and priority for public policy in this area, and the barriers to and need for greater disclosure of this type of information.

The speaker for this first Issues Dialogue on Owning and Counting Intangibles was Jonathan Low of the Cap Gemini Ernst & Young Center on Business Innovation. Mr. Low is the co-author of Invisible Advantage: How Intangibles are Driving Business Performance. He was introduced by Dr. Kent Hughes, Director of the Project on America and the Global Economy at the Woodrow Wilson Center.

Mr. Low began by outlining the two topics he wished to cover. The first was to summarize both his research and the research of others in the area of intangibles. The second was to discuss some of the policy implications. A number of agencies, including the SEC, the Federal Reserve Board and the Financial Accounting Standards Board (FASB) are looking into this issue in the United States while the EU and the International Accounting Standards Board are also involved in policy-making on the subject. It is an issue that affects a number of public policy areas, such as intellectual property rights, tax policy, and others.

Mr. Low’s basic message is that markets are already valuing intangibles. Markets are already looking at factors such as leadership, reputation, and credibility as important factors in determining companies’ value. His research shows that there is a direct correlation between these factors and financial outcomes of the company. Company managers need to be aware of these factors – as do policymakers.

Many business leaders and government officials already recognize the importance of intangibles in decision-making and capital allocation. However, most officials have not taken a proactive stance in the management of intangibles.

Mr. Low’s list of intangibles include:

  • Management
    • Leadership
    • Strategy Execution
    • Communication & Transparency
  • Relationships
    • Brand Equity
    • Reputation
    • Alliances & Networks
  • Organization
    • Technology and Processes
    • Human Capital
    • Workplace Organization & Culture
    • Innovation
    • Intellectual Capital
    • Adaptability

Contrary to the belief that intangibles can’t be measured, most companies are already capturing 70 percent of this data. Yet, a recent survey conducted by Mr. Low’s organization of chief financial officers revealed that they believe that financial information they are required to capture and disclose by regulatory agencies is “utterly worthless” to the managers. The challenge is marry the traditional financial information with the data on intangibles.

Mr. Low’s research into intangibles was sparked by an interest in the increasing gap between book value and market value of companies. That gap has continued to grow. This suggests that the current system of measuring what is driving business value is seriously broken. It also reinforces the belief that economic activity has less and less to do with the production of tangible goods and more and more to do with intangibles. If we are to properly allocate capital or develop tax policy, for example, it is important that we understand and can properly measure these intangibles.

The role of intangibles as value drivers continues to grow relative to the value of tangible assets. Research shows that market value is less and less correlated with the value of tangible assets (plant and equipment). Companies are clearly getting more market bang for their investment buck in intangible assets rather than in tangible assets.

As Mr. Low and his colleagues began to look into this issue of the gap between market and book value, they first surveyed institutional investors to better understand what these investors look at in companies. This survey revealed that 35 percent of their portfolio allocation decisions were based on non-financial (intangible) factors. Interestingly, information gathered by institutional investors on intangibles comes from sources other than companies themselves. A study of sell-side analysts (those who work for investment banks, brokerage houses, etc.) showed that the more they referred to intangible factors, the more accurate were their quarterly earning projections. The top ten list of the intangible factors that investors and analysts look at are:

  • Strategy Execution
  • Management
  • Credibility
  • Quality of Strategy
  • Innovativeness
  • Ability to Attract Talented People
  • Market Position
  • Management Experience
  • Quality of Executive Compensation
  • Quality of Major Processes
  • Research Leadership

Another study by Mr. Low’s organization of initial public offerings (IPOs) showed that intangibles were the only significant difference between the successful offerings and those which failed to increase in value. Traditional financial measures had no statistical correlation with future stock value. But intangibles did. The most important intangible was the alignment between corporate strategy and employee interests – something that in fact can be measured.

A survey of senior executives came to the same conclusion: the most important factors they were concerned about were intangible. However, there were significant gaps between the importance of the information and the quality of the information these managers were receiving from their own companies. According to Mr. Low, 81 percent of the senior executives surveyed said that the information they were getting on these intangible factors was not very good.

Yet, there is strong statistical evidence that if you can close the gap between the importance of the information and the quality of the information, you can improve stock market performance, compound annual growth and return on investment. This presents an important opportunity to both business managers and policymakers in that better capturing, measuring and managing intangibles can greatly increase company performance.

Interestingly, investments in technology were not found to be a differentiating factor in performance. The markets had already discounted technology investment. Technology is considered as the ante needed just to be in the game. What separated the winners from the losers are the organizational factors needed to effectively utilize technology.

When grouped together into a value creation index, these intangibles explained as much of companies’ market value as do traditional financial performance measures. In addition, improvement in this value creation index has a specific result in improvement in market value.

These value drivers include innovation, quality, knowledge of the customer, human capital, alliances, technology, brand equity, leadership, and environment. Alliances, brand equity, technology, and human capital were the most important drivers of value in non-durable manufacturing.

Each of these drivers can be measured using the number of specific indicators. Most of this data is already collected by companies. It is therefore possible to describe a company’s specific value drivers and then manage the company to improving those intangibles.

Case studies have shown over and over the importance of intangibles such as reputation, intellectual property and R&D, intellectual capital, and leadership. For example, Coca-Cola learned the value of reputation during the contamination scare in Europe.

While the rest of the world is already moving ahead with accounting principles to capture intangibles, the U.S. is moving somewhat slower. A number of European nations have specific proposals on measuring intangibles. The International Accounting Standards Board recently released their proposal, International Accounting Standard (IAS) 38.

According to IAS 38, an intangible asset is an identifiable non-monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes. Under IAS 38, an asset is recognized only and only if:

The asset is identifiable
The asset is controlled
Future benefits specifically attributable to the assets are probable
The cost can be reliably measured

As Mr. Low’s research shows, intangibles are identifiable, future benefits can be determined and cost can be measured. Control of intangibles can be a somewhat more difficult subject.

It follows from the recognition criteria that all of the following costs should be recognized as expenses:

All expenditures on research, not development
Start-up costs
Training costs
Advertising costs

According to Mr. Low, it is important for both business leaders and those interested in public policy to look at and understand the IASB guidelines since they are defining the nature of the discussion.

In summary, Mr. Low stressed the need to determine your critical intangibles, measure and benchmark those intangibles, undertake initiatives to improve your performance on key intangibles and communicate what you’re doing.

The last point is often forgotten. Right now there is a great opportunity to improve the information available to investors by including information on intangibles. It is to a company’s advantage to disclose this information and be as transparent as possible.

By including intangibles, we can do a better job in allocating capital – which is the key to future economic growth.

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Dr. Kenan Jarboe, President of Athena Alliance, outlined his organization’s interest in the subject of intangibles. Information assets are the fuel of the information economy. There is no separate group of workers involved in the creation of intangibles – everyone in every location is involved in creation and use of intangibles. The key issue is understanding how we utilize intangibles so that everyone benefits from the transformation to the information economy. Both accounting and intellectual property rules are necessary for the utilization of these information assets, as a market requires both being able to value an asset and to own that asset. For that reason, it is important at we get the rules correct to make sure that the market works for the benefit of all.


Dr. Jarboe then introduced the respondent, John Mitchell, who addressed the controllability or ownership issue. Mr. Mitchell is the principal of the law firm Interaction Law and was formerly Legal Director for Public Knowledge, a public policy organization concerned with issues of the public information commons. He began by pointing out his interest was more on the human side of the human capital formulation and on the intellectual side rather than the property side of intellectual property.

Mr. Mitchell’s basic question is where do we draw the line. Implicit in our understanding of the importance of education in building human capital is the notion that the individual acquiring that capital cannot sell it. Yet implicit in some of the notions about increasing and protecting intellectual property, human capital and other intangibles, is a transfer of human capital from the individual to the corporate balance sheet. There are already a number of ways to capture employees’ intangible assets and human capital so that it does not leave the company, such as trade secrets and non-compete covenants. Such protection is consistent with accounting requirements, such as those under IAS 38, for controlling an asset. The danger is that these types of protection could go too far, and decrease the value of these assets to the individual, such as someone who had a marketable skill but can no longer market that skill because of these types of restrictions.
He went on to point out that there may be a tension between these attempts to protect intangibles and the ways in which intangibles are used. For example, being considered one of the “best places to work” is considered a positive intangible of a company. Yet restrictive clauses on employees in an attempt to capture and protect their human capital would undermine a company’s rating as a “best place to work.”

According to Mr. Mitchell, it has been a recognized public policy goal to find a balance between corporate and individual rights. For example, many states place limits on non-covenants so as not to deprive the general economy of certain skills and knowledge.

In the last few years there has been an increase in areas covered under the rubric of intellectual property rights. For example, while the copyright on a book prohibited reproduction and distribution, it did not restrict the owner of that book from getting it or lending it to someone else. Nor did the copyright holder have any say over the technology used to produce the book. Now in the digital age, these concepts are under review. Copyright is being used to leverage control over digital technologies which may be dangerous both to corporations and to society at large. In addition, intellectual property rights are being asserted in areas where traditionally they have not been. For example, there is the case of a major retailer attempting to assert copyright over when announcements of future sale prices can be released.

Parenthetically, tied in with issue of control is the issue of who is placing the value on the asset.

Mr. Mitchell cited the video rental market as an example where more flexible control over intellectual property led to the creation of a revenue stream for the movie studios that would not have otherwise existed. The asset of the rental rights of videos could not be controlled by the movie studios and therefore could not be booked as an asset under the accounting rules Yet, that market has become a major source of revenues.

A more current example is the issue of open source software. Open source software has become both a major investment and a revenue source for companies such as IBM and HP. How will the accounting rules cope with this asset that is not under the control of the company?

In these cases, the lack of control over intangible assets may be more valuable to companies than having complete control. There is a parallel with the role of public goods, such as the highway system. No individual company owns or controls the asset, yet it is vital to companies’ prosperity. These public assets can end up helping one company more than another. But it is important to society at large that public investment in these assets continue. The same is true in human capital, where we cannot simply rely on companies seeking to identify and invest in the best and the brightest in exchange for exclusive rights to that human capital.

A key question is to identify which assets are best left to the public. We must then resist over-privatizing those assets which are better left to the commonwealth.

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During the question and answer period a number of issues were raised:

Dr. Jarboe began the discussion by raising the difference in managing intangibles as expenses, which traditionally is something business leaders attempt to minimize, and managing intangibles as an asset, which require long-term investments. This issue is tied in with the complicated issue of taxes, where assets must be depreciated over a long period of time and expenses are written off immediately, thereby lowering taxes. It also ties into accounting concepts of assets versus liabilities.

Mr. Low stressed that the key for management of intangibles is the ability to identify and measure the intangible, regardless of whether it gets classified as an asset or expense. Understanding how intangibles work, how they can be created and how (and to what extent) they can be controlled is important.

The question was asked specifically which countries have done the most work in this area. Mr. Low pointed to the Scandinavian countries, southern European countries and Asian countries (China, Korea and Taiwan) as examples.

One participant pointed out that we have always accounted for these intangibles, lumping them into the category of “goodwill.” Mr. Low noted that often-times the category of goodwill covers a variety of concepts that are not really drivers of value. He raised the example of the notion of synergy in mergers. According to his research, the true underlying values in mergers are intangibles such as brands, reputation, human capital and the like. The key is to identify the specific intangibles rather than simply utilize the inarticulate category of goodwill. Dr. Jarboe pointed out that we may be in the same situation economists found themselves a number years ago in studying productivity, where much of the gains were found to come from the catch-all residual category.

Another participant raised the issue of the nature of human capital, specifically how human capital is increased through learning. That improvement increases the market value of that human capital. Presumably, that potential increase in value would be reflected in compensation. In addition, the trend towards contingency work and independent contractors would undercut the notion of non-compete agreements. Thus, the market would presumably be correcting the balance between company and individual control over their intangible assets.

Mr. Mitchell pointed out, however, that there may be external benefits to society not captured in these market transactions. The danger may be that non-compete agreements may lock up that intangible asset so that it doesn’t get fully utilized, to the detriment of society as a whole. It is also difficult to separate out what is the public and what is the private investment in an intangible such as human capital. In addition, it is more difficult for individuals to be able to value and measure their intangible assets – leading to information asymmetries that distort the functioning of market.

He went on to point out the danger in relying upon private agreements by using the example of some entertainment companies that are attempting to circumvent the first-use rule (the restriction on the right of a copyright holder to prevent further sale or rental) through end licensing agreements. The market might correct for this by providing a discount to those who agree to, for example, not resell a book. But society may suffer from the restrictions on the used book market this would impose.

As an aside, Mr. Low mentioned that there is a software package being developed for bank loan officers to be able to incorporate educational levels as an intangible in making loan decisions. Dr. Jarboe pointed out the importance of making sure this software captures all forms of human capital and skills, both law degrees and plumbing skills. Such a broad definition of human capital would give poorer communities and individuals better access to financial assets needed to power economic growth.

It was also mentioned that for airlines, airport landing rights are important intangible assets. What is the role of the market vs. the government in the allocation of this asset?

A question was asked about policy priorities. Mr. Low stated that he believed the top priority was in the area of comparability of data. While the issue of comparability of data for accounting purposes covers a number of topics, it includes the ability to identify and measure these intangible assets. It also includes issues as to what information companies are required to disclose, so that investors get a clearer picture of companies’ situations. According to Mr. Low, we need to reform the accounting system which is no longer adequate to supply the information needed to value and manage today’s companies and to make informed public policy. One role for the Federal government would be to sponsor better research on these issues.

He also emphasized the need for increased interaction between U.S. agencies dealing with these issues and the activities of international bodies such as IASB.

The final question concerned why companies don’t make information on their intangibles more readily available. Mr. Low stated it was a classic case of information asymmetry. Part of the problem is that there are too many factors to focus on. In part, this speaks to the issue of corporate governance, especially concerning the combined role of chairman and CEO. One of the arguments that has been made for splitting these positions is the problem of information overload.

Mr. Low ended the session with a positive note that increasingly he finds companies understand the need to both capture and disclose information on their intangible assets. Progress is being made.


Download audio files for The Invisible Advantage: Owning and Counting Intangible Assets in the Post-Enron Era

Questions & Answers

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The Intangible Economy: About this forum series

The information, intangibles and innovation (I3
or I-Cubed) economy is now a reality. Information, knowledge and other
intangibles now drive economic prosperity and wealth creation. Intangible
assets – worker skills and know-how, informal relationships that
feed creativity and new ideas, high-performance work organizations,
formal intellectual property, brand names – are the new keys to
competitive advantage. Intangibles and information power our innovation
process, which is a combination of formal research and informal creativity.
These elements combine to produce the productivity and improvement gains
needed to maintain prosperity.

In this I-Cubed Economy, the rules have changed. But public policy has
not caught up with this new economic environment. Governments are struggling
with ways to utilize information, foster the development of intangibles
and promote innovation and competitiveness in the new global information
economy. Policy makers are grappling with the urgent need to frame policy
questions in light of the changing economic situation.

Issues of developing and managing intangibles underlie discussions on
a variety of subjects, such as intellectual property rights, education
and training policy, economic development, technology policy, and trade
policy. Crafting new policies in these areas will require infusing a
better understanding of intangibles and the information economy into
the public debate.

To help expand the dialogue, Athena Alliance and the Project on America
and the Global Economy of the Woodrow Wilson Center are co-sponsoring
a series of discussions on policies for the Intangible Economy. This
discussion series will explore the concepts and controversies surrounding
the issues of the I-Cubed Economy, including managing and regulating
intangible assets, fostering innovation and creativity and improving
international competitiveness. Our goal is to increase the understanding
of how we utilize intangibles so that everyone benefits from the transformation
to the information economy.